Most people are probably aware by now that the new year rang in some notable tax changes. These included a 3.8% Medicare surtax on investment income, which was designed to help assist with the costs of implementing the Affordable Health Care Act of 2010. The surtax applies to unmarried individuals with adjusted gross income in excess of $200,000 and married individuals who are filing jointly with adjusted gross income in excess of $250,000. The surtax, on the surface, seems simple: it applies to income derived from interest, dividends, annuities, royalties and rents not incurred in the ordinary course of a trade or business. However, there are some nuances that may catch many business owners by surprise.

A common issue occurs when a business owns the building where the business is operated rather than renting it from a third party. In the past, it was common and good practice to advise business owners to keep their business operations and their real property separate, usually by placing the real property in a limited liability company and then renting the space back. This organizational planning structure is referred to as a “self-rental.” For simplicity, self-rentals often use a 'triple net lease' whereby the tenants are responsible for all the costs and repairs associated with running the property, and there is no change to the real life operations of the business or management of the property, except on the tax returns.

This structure, however, brings in to play some very complicated regulations which define net investment income and determine whether or not income from the rental activity is passive or active. The self-rental structure triggers a unique exception in the Internal Revenue Code that provides that the character of the income from the rental activity is based on whether there is a loss or a gain. As it stands now, losses from self-rentals are treated as passive losses and gains are treated as non-passive income and not net investment income. A passive loss can only be used to offset passive income; however, non-passive losses can offset both passive and non-passive income.

However, the new regulations implementing the Medicare surtax create some anomalies and leave open questions. It is entirely possible that such self-rental activity could be considered both a non-passive activity and not net investment income for purposes of Internal Revenue Code Section §469 but considered a passive activity and, therefore, net investment income for purposes of imposing the Medicare surtax. Simply put, the Internal Revenue Service wins twice.

Some business owners would benefit by revisiting their current self-rental structure, possibly by converting their rental agreements away from triple net leases and becoming more involved in the rental activity. In the end, the net income tax result is the same but the rental activity would rise to a trade or business and thereby avoid the Medicare surtax.

However, the standard for determining whether or not an activity is a trade or business is very fact intensive and should be examined carefully with a trusted advisor. It is important that business owners with the self-rental structure look at this issue now or you may be surprised when you file your 2013 tax return in 2014.

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